When a company reports earnings, I have to be careful when booting up Internet Explorer and jumping on Bing. The reason is because the last thing I want to see is an article on the results or the pre-market trading; I know my mental limitations, and undoubtedly will be affected by what I see from the financial media or the market. The reason I don’t want to see what they have to say is because we have very different goals: While they are often concerned with whether or not the company beat by a penny, I want to see positive developments in the business that reflect progress in a company’s long-term vision – even if that means forgoing the opportunity to report a near-term beat.

J.C. Penney’s (JCP) is an extreme case as to why: As I look at what others seem to be focused on (particularly overall sales, without focusing on – or in a lot of cases even mentioning – the results of the shops), it amazes me how different that is from what I’m concerned with. For any long-term investor in JCP, I think it’s quite clear what is relevant; one, are the financials solid, and will they be able to finance the company’s transition to the shops model (which naturally comes with significant up-front investment)? Second, how long will it take? And finally, is there any reason to believe that if they can finance this transformation, it will be successful?

From what I’ve read in the financial media, nobody else seems to be too concerned with answering these critical questions. In reviewing the third quarter results, I will attempt to address these key concerns for long-term owners in JCP:

Can It Be Financed?

Answering the first question involves looking at all three financial statements. Let’s start with the operational results (income statement): Comparable sales were down 26.1% in the quarter and total sales decreased 26.6% to $2.93 billion. As a result, year-to-date same-store sales are now down 22.3%. As explained on the call, the further deterioration in Q3 (in comparison to Q1 and Q2) was entirely due to a change the company made in August to move from three pricing levels (which included Month Long Value) to two (Everyday and Clearance) – with conversion dropping immediately on those items, the week the change was implemented (traffic was unchanged).

For the long-term investor, there’s a silver lining in this – since the change has been made, there have not been any commentary or stories from the media suggesting that the pricing strategy is too difficult to understand (a big complaint when the three tiers were first announced).

On the bottom line, the company reported a GAAP loss of $0.56 per share; after adjusting for the gain on non-core asset sales and two comparatively small non-cash items, the adjusted loss was $0.93 per share, bringing the year-to-date adjusted loss to $1.55 per share.

I think the best way to address the financing question is to look at the cash flow statement through the first nine months of the year, then to look at what this means in terms of assets and liabilities. Year-to-date net cash from operating activities has been directly impacted by a $230 increase in working capital, with inventory being a $446 million draw since the first of the year (remember, big build-up heading into peak selling season). In addition, we have $112 million (year to date) in non-cash restructuring and asset impairment charges; after adding up the reported items, the outflow in cash from operating activities for the quarter and year to date totaled $48 million and $655 million, respectively.

Moving down the cash flow statement, we have a few other key items; capital expenditures have been material, with the year-to-date total coming in at $580 million (compared to $469 million in the same period of 2011). Within the investing line, this has been largely offset by the $525 million in proceeds from the sale and redemption of non-core assets.

Moving to the financing line, with see two positives – the first is an outflow of $230 million for the repayment of long-term debt; the next payment of $200 million is not due until October of 2015. Second, we have the $86 million in dividends paid year to date; with the elimination of the dividend, this cost will disappear entirely in 2013. After adjusting for the $46 million year-over-year difference in proceeds from the exercise of stock options and excess tax benefits, we are left with roughly $270 million in financing outflows that are non-recurring.

To summarize, we have a year-to-date decrease in cash and equivalents of $982 million. On the positive side, we have $270 million in non-recurring financing outflows and a $230 million increase in working capital that should decrease considerably by year end. The other big item (which I’m not entirely clear on) is the $224 deferred tax outflow on the cash flow statement; any help with interpreting this line item (in order to assure appropriate accounting) would be appreciated.

On the negative side, the company received $525 million in proceeds from the sale of non-core assets, which can only be replicated as you continue to liquidate non-critical assets like REIT units (Hannah said that the company continues to have “several hundred million dollars” of opportunity in the liquidation of non-core assets, particularly ownership positions in mall partnerships). Excluding the asset sales and the outflows mentioned, I estimate the normalized cash draw at $800 to $1000 million (I made no adjustment for the deferred tax outflow to be safe).

The company ended the quarter with $525 million in cash and equivalents, down $363 million from the second quarter. Within that decrease we have the company’s repayment of $230 million in debt and $341 million in Q3 capex spend (eight shops, technology investment, etc.), offset by non-core asset sales. Inventory was a big positive aspect, and was down by $1 billion year over year (in line with sales); at this point, it stands at $3.36 billion – and by my estimate could decline an additional $400 million between Q3 and year end (to end in-line with 13 weeks of inventory).

On Jan. 1, 2013, the company anticipates having $2.5 billion in liquidity, with $1 billion in cash and equivalents and an additional $1.5 billion available from an undrawn asset-backed line of credit (with the capacity to be increased to roughly $2 billion). When we consider the “several hundred million dollars” of opportunity left in other/non-core assets, three years until the next debt maturity, and the ability to sell core assets if necessary (Penney’s owns roughly 55 million square feet of real estate between their stores, home office, distribution centers, etc.), it starts to become clear how there’s plenty of wiggle room on the balance sheet (obviously this assumes that the business turns a corner at some point in the future – it simply doesn’t require this to happen immediately). From this data, Mr. Hannah concludes that the company’s balance sheet is “firmly positioned to be able to support our intentions.”

How Long Will It Take?

Obviously this is contingent upon the first question; assuming all the aforementioned factors play out in-line with management’s expectations (and I think you would see a big push towards monetizing real estate and other non-core assets to finance the transition if they are not), the plan is to have the remainder of the transformation completed in the next 36 months.

At the end of Q3, we have hit the 10 shop mark. While this was a relatively rapid change, it still leaves nearly 90% of the selling space in targeted stores unchanged. In the next 12 months, JCP will have 40 shops, accounting for 40% of the square footage in transformed stores. From that point, Penney’s will add 30 shops per year, bringing the total to 70 in November 2014, and the transformation should conclude with 100 shops in November 2015.

Will It Be Successful?

Naturally, “success” can mean many things. In this instance, I will measure it in terms of Bill Ackman’s 2012 presentation at the Ira Sohn conference, where he targets sales of $177 per square by 2015. Now, this measure includes home office and other unproductive space (non-selling), so we must adjust the sales floor sales per square foot to compare the measure presented by JCP on the third quarter call and this value.

Gross square footage at JCP (the company as a whole) is 111 million; 34 million is tied to backroom, offices and services; 13 million is attributed to small stores (which are not going through the transformation); and the remainder, 64 million, is what we’re targeting – what we will call transformation square footage. At this time, 89% of this 64 million square feet is the traditional J.C. Penney (57.2 million), with the 10 shops added to the store (JCP specialty) accounting for the remaining 11% (7.2 million). In the quarter, we got our first look at the performance for the shops:

Type

J.C. Penney – Promotional

jcp - Specialty

Square Feet

57.2M

7.2M

% of 64M

89%

11%

Sales per Sq Ft

$134

$269

To be clear, this measure for the specialty stores includes their fair share of the aisle, the cash wrap, etc. It proportionately allocates the space in the store beyond the merchandising pad. Looking at the 6 million square feet of the 7.2 million that is new to the shop format in 2012 (backing out Sephora and MNG by Mango), sales per square foot were up 32.8% year over year, from $180 per square foot to $239 per square foot (the lower productivity figure is largely due to the strength of Sephora, which skews the data higher at $561 per square foot in 2011). To get an idea of how this might comp over time, let’s look at our only relevant example – Sephora:

Year

2007

2011

CAGR

SSS per square foot

$457

$561

5%

I think drawing any sort of conclusions from this (in determining how the 2012 shops will comp) is a bit of a stretch, but I think it at least provides some color. By the way, Sephora has continued that pace, and is up 5% on a same store sales basis to date in 2012; I’m not sure what to conclude from this, but certainly find it interesting that Sephora’s taken on a life of its own within JCP.

On the call, Ron Johnson walked listeners through the results shop by shop, with some specifically called out by name (others were left confidential for competitive reasons at the request of the suppliers for those shops). Let’s take a look at that data:

Shop Number

Name

Before

After

Change

1

Unknown

$69

$207

200%

2

Unknown

$93

$160

72%

3

JCP Women

$151

$298

97%

4

JCP Men

$152

$121

-20%

5

Unknown

$187

$274

47%

6

Unknown

$199

$285

43%

7

Unknown

$209

$265

27%

8

Arizona

$235

$207

-12%

Total

$180

$239

33%

Here’s some commentary on the identified shops:

Shop No. 3, JCP Women, is now the company’s most productive shop (by sales per square foot) outside of Sephora. As noted by Ron Johnson, this is on first year volume, and will get better and better (his words) as they learn to merchandise the shop more productively.

Shop No. 4, JCP Men’s, was a bust in the quarter. The main problem (as identified on the call, and as noticeable when in the stores) was the product assortment, with way too many bright colors like oranges and purples. Considering that the average American male is much more likely to pick a navy, grey or other “basic” color over a bright purple, JCP simply overshot their target customer (remember, trying to be America’s favorite store, not targeting the few fashionably sophisticated among us). As noted by Ron Johnson, this problem has been noted, and will be fixed for February (the next time the company reports earnings).

Shop No. 8, Arizona, went down by low double digits – a big shock considering that this was the company’s most productive shop space taken heading into the third quarter. Management’s explanation in this shop was a bit more nuanced than for JCP Men (I’m not going to go into the detail of the merchandising strategy – this article's already long enough!), but they noted that they’re working on getting the product offering right.

Before we go on, I just want to add some relevant food for thought: The current shops are essentially taking products that JCP already sells and simply doing it better. The real fruition of this strategy as originally laid out comes from differentiation in both presentation and product – this will begin with the launch of Joe Fresh shops in mid-March 2013.

Looking Ahead

Let’s fast forward to 2015, and assume all the shops are completed (100% jcp Specialty), with sales unchanged at the current shop average of $269 per square foot across the entire 64 million of transformation square footage. Assuming $134 per square foot at the 13 million of small stores (in-line with J.C. Penney – Promotional), this brings us to $170 per square foot companywide:

Transformed

64M

$269/sq ft

Small

13M

$134/sq ft

Backroom/Office/Services

34M

$0/sq ft

Total JCP

111M

$170.80/sq ft

As we can see, this isn’t too far off from what Ackman was modeling for 2015 (at the $239 per square foot, the comparable total figure would be right around $154); to put that $177 estimate into context, JCP was expected to earn $6 per share in fiscal 2015 at that level, assuming the other variables held (gross margin at 40%, expenses under 30% of sales, etc.). Again, as with the figures from earlier, I would be careful with getting too excited about these figures or extrapolating anything too far out into the future. I simply want to point out that the 33% increase in the 2012 shops from the comparable period is a big step ahead for JCP.

Conclusion

Ron Johnson had this to say about the future of Penney’s on the conference call: “It’s really becoming a tale of two companies… one is J.C. Penney, a promotional department store; the other is jcp, which is a start-up, which is a specialty department store. And it turns out what’s good for one isn’t necessarily good for the other – and that’s why we’ve seen this year, J.C. Penney has performed tougher than we’ve expected… but the good news is jcp is much better than we imagined. As we wind down J.C. Penney over the next 36 months, my job is to deliver as best it can and generate as much cash as possible to fund the new jcp.”

To be clear – the fact that 90% of the “to be transformed” store space is struggling is a real concern (the company specifically noted the troubles in Home – for anybody who read about my recent store visit, this probably shouldn’t come as a big surprise). When we account for the continued growth of Sephora plus the strength in the new shops, this means the problem in the remainder of the store looks materially worse than the headline figures. If this problem persists, JCP will be put in a position that forces them to make some unpleasant decisions (I think they’ve hinted that a potential transaction with the 400 or so unchanged stores would be a possibility).

In 365 days, 40% of the store will be comprised of shops – a four-fold increase from today. If the results of those new openings are anywhere near the level of the current formats, the financials will look much different than they have so far through the first nine months of 2012.

As I noted in the first paragraph, looking at the stock price for advice can be toxic – particularly after the beating JCP has taken over the past few months. I continue to believe what I’ve thought all along: For the investor willing to bite the bullet in the near term, I think this strategy has some real long-term advantages that will be difficult to replicate by competitors if it ultimately proves to be successful. The third quarter shop sales, despite the fact that they’ve been glossed over by the financial media (headline after headline read that sales plummeted 26.6%), are the first quantification of where this strategy might take JCP.

I feel more comfortable with the shops strategy today than at any previous time (it’s nice to have some hard numbers). The figures presented suggest that this is a change worth making - and that we’ll be increasingly clear over the coming 12 months.

I added to my position in JCP on Monday and will likely continue to do so if the market is feeling generous and lops another 10% to 20% off the market cap over the coming weeks. As always, I look forward to different points of view or anecdotes about your experience with JCP.

Another way to see it, from solely a valuation standpoint, is that Michael Price says the real estate is worth $15 per share. The sales per share is approx. $50-60 (sales are in decline overall, so I'm allowing for that). But with the stock trading at $17, you're in essence paying $2 per share for a depressed $50 per share of sales.

Then when you look at the brilliant strategy of Ron Johnson, the sales can expand and the profit margins can expand. I think Ackman is right, I think Ron Johnson is moving quickly while patiently waiting for the results to speak loudly. At the price of $17, the upside/downside ratio has got to be 3:1 on a very conservative basis. I think it could be an 10:1 could be a more reasonable view.

Coat-tailing these two guys, at this price, seems to produce favorable odds with minimal downside. I acknowledge the difficulty of turnarounds, but I see this as a transformation more than a turnaround.

I agree - I think the risk/reward has become very, very attractive. To put Michael Price's comments into content, he said in a recent Bloomberg interview that he thought it was "trading for probably half of intrinsic value" - at the time, the stock was trading around $27.

Here's what he said about real estate:

"At some point, some real estate owner other than a retailer can come in with a very high quality tenant and cut a deal with this interest rate environment and get $15 a share for real estate."

Thanks for the article. Sears just dropped 18%. both jcp and shld selling around bv of 1.0. Sears has had 6 years of losses more or less though. Personally, I like jcp better. I remember when Toy launched Lexus, I wondered how the heck are they going to compete against German luxury vehicles. Boy, was I wrong about that. People's perceptions don't change overnite, but they do.

Agreed, especially for a brand like JCP where for so many people (particularly my age cohort), it is essentially unknown (I would bet 90% of people my age have no idea what's going on with the transformation); on the back end of this transformation (assuming we get there), this model should be very attractive to a younger (and less focused on coupons) buyer - a group that doesn't have any ingrained image of Penney's. I think $15 for this balance sheet, plus the potential upside if it plays out as planned, makes JCP a steal. Thanks for the comment!

one other thing; what none of us has in the discussion is the ability of Johnson and Co. to do something RIGHT NOW about the lagging sales in the old portion of JC Penny. In the last call he said that they had had no promotions for basically this year. He spoke over and over again about "how that was a great learning experience-" that being this failure or that failure to boost sales. But then he went on and on and on about what JCP was going to do to pull people into the stores and offer them "generosity" events. They are still moving the old inventory from the space replaced by the new shops...would have thought this had already occurred but eventually it has not. So this transition is still being burdened by old inventory. And that will continue but hopefully at a much slower pace- I would think they would move it all in this quarter. Going forward as each new shop is built, the old inventory of that space must also be laid off. Again hopefully they have had plenty of time to plan this in advance as they know the schedule for the new shops unlike this year where they inherited a large amount of excess inventory to move. Among their listed sources of future cash is a continued reduction in the amount of working capital needed for their operations.The question which is of most concern to me is just how successful they will be this quarter in pulling shoppers into the stores and then selling them things. It is one thing to be able to build a new concept. It is another to sell it. As optimistic as I am about the future of the new JCP, I am just as concerned about the ability of this management to market and sell what JC Penny is currently offering. We can all hold our breaths until the next financial release in three months. In the meantime I am giving my daughters JCP gift cards for Xmas...

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